Risk management and capital Management are two sides of the same coin. Both of these indicate that the sufficient capital contribution in the business provides stable resources to help the owner to absorb any losses arising from the risks in a business. The objective of Capital management as well as its risk appetite is to reach solvency ratio adequate for its lending activities during a period of difficult business conditions. The available capital in the business must be enough to satisfy regulatory and internal capital requirements.
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What are Risk management and capital Management?
Risks that banks are confronted with:
The business of banking is confronted with multiple numbers of risks viz. credit risk, liquidity risk, operational risk, reputation risk, legal risk, market risk, strategic risk, country risk, counter -party risk, contractual risk, Access risk, and systemic risk and so on. Nevertheless, like in any other business risk taking in banking is also inevitable as it also presents possibilities of a rewarding result. Let’s examine here how various types of risks arise in the banking sector.
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Risks that banks are confronted with;
Credit Risk:
Credit risk arises when a bank borrower or counter- party fails to meet his obligations according to specified schedule in terms of predetermined agreement either due to genuine problems or willful default. Banks are using two broad methodologies for computing their capital requirements for credit risk as per Basel II guidelines. First method is standardized approach and second method is Internal Rating Based approach.
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How banks measure credit risk?
Credit Risk Mitigation:
Credit risk mitigation strategies in a bank taking place in two stages namely pre-sanction stage and post sanction stage of loans and advances. Pre-sanction process involves identification of borrower, the purpose of the loan, quantum of loan, period of loan, source of repayment, security for advance, profitability, pre-sanction unit inspection, appraisal of credit proposal, and sanctioning of the loan/limits. The post-sanction monitoring includes proper documentation for the loan/limits sanctioned, stamping, execution, execution of documents by special type of borrowers, attestation of documents, registration of mortgage/memorandum of the mortgage, registration with the Registrar of companies (ROC), post disbursement follow up/unit inspections etc.
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Risk mitigation strategies in banks
Credit Migration:
The ratings of a company so awarded are subject to periodical change depending upon the credit risk condition of the company improves or deteriorates. Given enough historical data, the likelihood is calculated that a company at a particular rating will migrate to a different rating over some time period (say one year).This method of measuring credit risk is known as credit migration or Credit Rating Migration Risk.
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What are credit migration and credit metrics?
Credit Metrics:
Credit Metrics approach measures credit risk in a portfolio model for evaluating credit risk. This methodology is used to quantify the credit risk across a broad range of instruments, including traditional loans, commitments and letters of credit; fixed income instruments; commercial contracts like trade credits and receivables; and market-driven instruments such as swaps, forwards and other derivative. The relationships between exposure and the credit metrics framework develop a portfolio value due to credit risk. As and when a debtor’s (bond issuer’s) credit rating falls, the debtor’s bond cash flows become more deeply discounted and the total bond value drops accordingly. On the other hand, if a debtor’s rating improves, the cash flows are discounted less deeply, and the bond values will rise.
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What are credit migration and credit metrics?
Market risk:
The ‘Market risk’ is an umbrella term used for multiple types of risk associated with adverse changes in market variables that include Liquidity Risk, Interest rate risk, Foreign exchange rate risk and equity price risk. Market risk causes substantial changes in income and economic value of banks. The Bank of International Settlements (BIS) defines market risk as “the risk that the value of ‘on’ or ‘off’ balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices”. Basel II Framework offers a choice between two broad methodologies in measuring market risks for the purpose of capital adequacy viz. (1)The Standardised Measurement Method (2) The Internal Models Approach (IMA)
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Operational risk:
Basel Committee on banking supervision has adopted a common industry definition of operational risk. Operational risk is defined as the risk of direct or indirect loss resulting from breakdowns in internal procedures, people, system and external events. Examples of operational risk are frauds, system failure, error in financial transactions, failure to discharge demand of contractual obligations due to insufficient funds etc. The revised BASEL II framework offers the three approaches viz. The Basic Indicator Approach (BIA), The Standardised Approach (SA), Advanced Measurement Approach (AMA)for estimating capital charges for operational risk.
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How operational risk measured?
Risk Weight table for different category of Assets:
The Risk Weighted Asset (RWA) is a measurement designed to evaluate the element of risk involved in each asset held by the bank. For example Cash held by bank is an asset with zero risk, where as other assets of the bank such as loans and advances, guarantees etc., are vulnerable to risk of default. Thus, such assets are called risk weighted assets. Banks make provisions on those risk weighted assets to meet future unforeseen losses.
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Risk Weight table for different category of Assets
Risk management in agriculture:
Banks provide a number of credit facilities to customers engaged in activities related to agriculture. Many a time banks take the brunt when unforeseen disaster strikes the farmers in the form of ‘on-farm loss’ and or ‘off-farm losses. These types of losses caused mainly due to production risk and price risk. The risk management in agriculture involves choosing among alternatives that mitigate financial effects that can result from such uncertainties.
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What is risk management in agriculture?
Risks in Foreign Exchange dealings:
The business of foreign exchange dealing is confronted with multiple numbers of risks viz. Rate risk, Open Position risk, Maturity Mismatches risk, overtrading risk, Cash Balance Risk, Counterparty risk, Country risk, Fraud Risk, and so on. Nevertheless, like in any other business, risk taking in forex dealing is also inevitable as it also presents possibilities of a rewarding result. Let’s examine here how various types of risks arise in the foreign exchange dealings.
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Risks in Foreign Exchange dealings
Fraud and cheating:
The difference between fraud and cheating lies in their variety.
According to law fraud is “A false representation of a matter of fact whether by words or by conduct, by false or misleading allegations, or by concealment of what should have been disclosed that deceives and is intended to deceive another so that the individual will act upon it to her or his legal injury.
What is the difference between fraud and cheating?
LTV ratio and Risk Weight percentage on housing Loans:
Loan to value ratio means Loan amount disbursed by the bank proportionate to the property value. LTV ratio is calculated by dividing the amount borrowed by the appraised value of the property, expressed as a percentage. For example, if you buy a home appraised at Rs.1 Crore for its appraised value and make a Rs.20 lac down payment, you will borrow Rs.80 lac resulting in an LTV ratio of 80% (80,00000/100,00000).
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Loan to value ratio and Risk Weight percentage on housing Loans
ALCO and ALM systems in banks:
A risk management committee in a bank that evaluates the risk associated with the bank’s assets and liabilities is known as asset-liability committee (ALCO).ALM (Asset liability Management): ALM is the system of measuring and managing various risks banks or financial institutions that arise due to mismatches between the assets and liabilities exposed during the course of their operations
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ALCO and ALM systems in banks explained
Meaning of Capital charge and calculation of capital requirement:
In banking parlance ‘Capital charge’ refers to capital requirement (also known as regulatory capital or capital adequacy). The capital charge is usually articulated as a capital adequacy ratio (CAR) of equity that must be held as a percentage of risk-weighted assets. The banking regulator of a country tracks a bank’s CAR to ensure that the bank can absorb a reasonable amount of loss and complies with statutory Capital requirements. Higher CRAR indicates a bank is better capitalized.
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Meaning of Capital charge and calculation of capital requirement
Funding Liquidity and Managing Liquidity:
The International Monetary Fund (IMF) defines funding liquidity as “the ability of a solvent institution to make agreed-upon payments in a timely fashion”. According to the IMF, funding liquidity is the ability lending agency agrees payment with immediacy. Funding liquidity is the availability of credit to finance the purchase of financial assets for a business and also capability to assume liability and settle obligations.
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Funding Liquidity and Managing Liquidity explained
Internal Capital Adequacy Assessment Process (ICAAP)
The regulatory capital framework placed by RBI under Pillar 1 has increased importance on risk management and banks are required to employ suitable procedures and systems in order to ensure their capital adequacy. These procedures are referred collectively as the Internal Capital Adequacy Assessment Process (ICAAP).
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What is Internal Capital Adequacy Assessment Process (ICAAP)?
Supervisory Review Process (SRP):
The supervisory review process (SRP) of bank management is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks. SRP includes assessment by the supervising authority to ensure how well the banks are evaluating the capital needs commensurate with their risk. Supervisor shall intervene wherever necessary to encourage them to develop and use better risk management techniques for monitoring and managing the risks.
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What is Supervisory Review Process (SRP)?
Market Discipline:
In general, market discipline is defined as the transparency and disclosure of the risks associated with a business or entity.
In case of banks, market discipline refers to the obligation by the banks and financial institutions to conduct business while considering the risks to their stakeholders in the passage of their day-to-day operations. Therefore, bank managements have strong incentives to avoid risky loans and other investments.
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Off Balance Sheet Exposures:
Off balance sheet exposures refer to activities that are effectively assets or liabilities of a company but do not appear on the company’s balance sheet. The off-balance sheet exposures in banking activities refers to activities that do not involve loans and deposits but generate fee income to the banks. The non-fund based facilities like Issuance of letter of guarantee, letter of credit, deferred payment guarantee, letter of comfort; Investments of clients held by an investment company etc. which are contingent in nature are some of the examples off balance sheet exposures.
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What is off-balance sheet exposure?
Current Exposure Method:
The Current exposure method (CEM) is a measurement of the replacement cost within a derivative contract in the case of a counterparty default. Here, the credit equivalent amount of a market related off-balance sheet transaction calculated using the current exposure method which will be the sum of current credit exposure and potential future credit exposure of transactions like swaps, forwards, options, and other contracts.
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What is current exposure method of credit exposure?
Standardised Approach for Counterparty Credit Risk (SA-CCR)
The standardized approach for counterparty credit risk (SA-CCR) is a new computational method for exposure at default (EAD) under the Basel capital adequacy framework. This approach replaces the Current Exposure Method (CEM), used by banks in India, for measuring exposure for counterparty credit risk arising from derivative transactions, with effect from April 1, 2018. The general structure of SA-CCR remains same as that used in the CEM, consisting of two key regulatory components: replacement cost and potential future exposure.
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Standardised Approach for Counterparty Credit Risk (SA-CCR)
Financial Stress testing:
Stress test is a process or simulation technique that evaluates an institutions reaction to different situations. Stress testing and capital planning are increasingly linked to many risk management processes that require coordination across risk, treasury, and financial planning and analysis functions. Banks have been using stress tests to evaluate their potential vulnerability to certain crisis scenario that would affect the value of their portfolios. The vulnerability is usually measured with reference to the bank’s profitability and /or capital adequacy to respond effectively to various, adverse scenarios.
What is Financial Stress testing?
Scenario Analysis and sensitive analysis:
Scenario Analysis is a financial process through which investors & business managers can determine the amount of risk they are taking before making the investment or starting a new project. In the business environment, fluctuations are largely based on external factors like the change in demand for a company’s product or new regulations of the Government that may impact on the profitability of the project etc. The method of changing the value of those sensitive variables and observe the effects of changes on the revenues is known as sensitivity analysis.
What is Scenario Analysis and sensitive analysis?
Contingency planning:
The contingency planning is a regular part of risk management for exceptional risk though unlikely, may have disastrous consequences when an unexpected event or situation occurs. In the other words, contingency planning is a process that includes risk assessment and a mitigation strategy for those risks. It generally refers to a negative situation like direct or indirect loss resulting from breakdowns in internal procedures, people, system and external events like frauds, system failure, error in financial transactions, failure to discharge demand of contractual obligations due to insufficient funds, data breach, major network failure etc. that may affect the financial health or reputation of an organization or organization’s ability to stay in business.
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Duration or Macaulay duration:
‘Duration’ as the term suggests, is expressed as a number of years and measures a bond’s sensitivity to change in interest rates. The ‘Duration or Macaulay duration’ measures the price volatility of fixed income securities. Usually, the higher the duration, the more is the volatility in the prices. To be precise, it measures the change in market value of security due to 1% change in interest rates. In the other words it may be explained as the time an investor would take to get back all his invested money in the bond by way of periodic interest as well as principal repayments and also the present value of future payments received from a security/bond.
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What is Duration or Macaulay duration?
Modified Duration
Modified duration is a concept that interest rates and bond prices move in opposite directions. It tells you how sensitive a bond is to interest rate changes. It is expressed in a formula that expresses the measurable change in the value of a security in response to a change in interest rates.
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Derivative:
In a layman’s language, derivative means profit or loss derived from something. The most common derivative instruments used in financial markets are the forward contract, options, forward rate agreement, futures contract, interest rate swaps etc. The characteristic and value of these derivative instruments are derived from underlying assets like currencies, Interest rates, stocks indices, precious metals, bonds, and stocks etc.
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Various types of derivatives and their uses
Forward contract:
A forward contract is a privately negotiated agreement between two parties to buy or to sell an asset at a specified price on a future date. For example, in foreign exchange market ‘forward contract’ means an exchange agreement between two parties to deliver one currency in exchange for another currency at a forward or future date.
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Futures:
Both forward contract and future contract are similar in nature. The main difference between the two is that the forward contracts are privately negotiated whereas the futures contracts are standardized and traded on an exchange. Futures are traded on organized exchanges whereas the Forwards are bilateral contract traded ‘over the counter’. The contract of futures can be reversed with any member of the Exchange, but in the forward contract, the contract can be squared off only with the same counterparty with whom the contract was originally entered into.
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Difference between forward contract and futures contract
Options:
Option is an agreement between two parties offering to buy or sell a security (a stock, bond, commodity or other instruments) from or to the other party at a specified price within a specific time period. In option contracts, there is no obligation on the part of buyer or seller to buy or sell the asset at ‘exercise price’; hence the parties to the deal call it an “option.”
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What is the meaning of options in security market?
Swaps:
A ‘Swap’ is an act of exchanging one thing for another. In derivative market, currencies swap, interest rates swap or commodities swaps are most common.
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What is the meaning of swap transactions?
Credit spread:
In banking jargon the word ‘spread’ is used in issuance of corporate bonds, interest levied on loans and in foreign exchange transactions. In foreign exchange transactions the difference between the buying rate and selling rate is referred as spread or margin. The term ‘credit spread’ is used in the fixed income corporate bonds and bank loans. It is the risk premium add-on to the base interest rate used when pricing corporate debt issues. In bank loans credit spread (known as pricing) is used over base rate or MCLR. The spread is determined on the perceived loan repayment or prospects of bond repayment to the investors.
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Basel Accords:
Basel accord is a global capital measures and capital standards which stipulate on how much capital a bank should have in place in relation to the risk it undertakes. The guidelines on above regulatory standards are formulated by Basel committee on banking supervision (BCBS). Basel committee is constituted by Governors of Central Banks of G-10 nations in 1974. The first guidelines issued by Basel Committee are known as 1st accord of Basel or BaseI I accord. The second round of formulated guidelines on capital measures and capital standards by Basel Committee came into existence in June 2006 (The detailed guideline issued during 2007). This accord is known as Basel II accord. In July 2009 BCBS formulated guidelines on capital measures and capital standards and made some changes and enhancements to Basel II accord. This is known as 3rd accord of Basel or Basel III accord. Since the committee’s headquarter is in BASEL (Switzerland), it is called Basel Committee. It has now nearly 30 member nations including India, with 12 nations as permanent members.
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Basel III rule:
The Basel III rule introduced several measures to strengthen the capital requirement of banks across the globe and presented more capital buffers to supplement the risk-based minimum capital requirements. This is to ensure that adequate funding is maintained in case there are other severe banking crises. The Reserve Bank of India introduced Basel III norms in India in 2003 and aims to bring in all commercial banks by March 2019. In India, lenders have to adhere to these regulations by March 2019. Compared to Basel II frame work, the Basel III framework prescribes more of common equity, creation of capital buffer, introduction.
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What is Basel III, why it is important?
Three pillars of Basel II:
First Pillar of Basel II deals with maintenance of regulatory Capital calculated on three major risks the bankers are facing viz. Credit risk, Operation risk and Market risk. Second Pillar of Basel II deals with the regulatory answer to the first pillar, which enables the banks to review their risk management systems. Third Pillar aspires to balance the minimum capital requirement and decision-making. The market participants are enabled to gauge the capital adequacy of a Bank with the help of set of mandatory disclosures prescribed in third pillar.
What are three pillars of Basel II?
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Restructuring of loan:
A restructured or rescheduled account is practically a new loan replacing the older account. Restructuring of loans involve modification of terms and conditions of the loan usually with longer period for loan repayment with lower amount of installments. Among other things restructuring may include revision of rate of interest and securities. Normally, restructuring of loans takes place when a borrower approaches the bank for support in a condition where he is unable to repay the regular installments of loan due to cash-flow mismatch or other genuine financial issues.
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What is the restructuring of a loan?
Non-Performing Assets (NPA):
An asset, including a leased asset, is called NPA when the asset ceases to generate income for the bank. Such assets of the bank are called Non-Performing Assets (NPA). If interest and or installment of principal amount of loan remain overdue for a period of more than 90 days, of term loan or the account remain ‘out of order’ in case of overdraft/Cash Credit account or the bills purchased /discounted remain overdue for a period of more than 90 days the account, such accounts will be classified as NPA.
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Prudential norms for income recognition and provisioning
Loss Assets: A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly. In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value. If the loan is not repaid even after it remains sub-standard asset for more than 3 years, it may be identified as unrecoverable by internal / external audit and it would be called loss asset
Doubtful Assets:
If an account remains in substandard category for a period of 12 months, the account will be classified as ‘Doubtful Asset.’ A loan classified as doubtful.
Sub-standard Assets: If interest and or installment of principal amount of loan remain overdue for a period of more than 90 days, of term loan or the account remain ‘out of order’ in case of overdraft/Cash Credit account or the bills purchased /discounted remain overdue for a period of more than 90 days the account. If the borrower does not pay dues for 90 days after end of a quarter; the loan becomes an NPA- substandard asset and it is termed as ―Special Mention Account (SMA).
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Prudential norms for income recognition and provisioning of NPAs
Gross NPA and Net NPA:
Gross NPA: Gross NPA is the total amount outstanding NPAs in the borrowal account, excluding the interest receivable. As per RBI regulation, once the account is classified as NPA interest cannot be debited to the NPA account and apportions it as profit.
Net NPA: The Reserve Bank of India defines Net NPA as Gross NPA minus (i) to (iv) the following- (i)Balance in Interest Suspense account + (ii) DICGC/ECGC claims received and held pending adjustment + (iii)Part payment received and kept in suspense account + (iv) Total provisions held.
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The difference between gross NPA and net NPA explained
Gains of NPA recovery:
Banks are required to set aside a portion of their operating profit as provision. Higher level of NPAs will increase the amount of provision thereby impacting the profitability. This will in turn adversely affect the Net Interest Margin (NIM) and capital adequacy ratio of the bank. NPA recovery leads to multiple gains to the bank. Every Rupee recovered adds-up cost-free resources to the bank. The recovered money can be recycled for further lending which enhances the current earning of the bank. The operating and net profit of the bank would improve. The capital structure of the bank would be strengthened. Recovery in NPA accounts improves the efficiency and profitability ratios of the bank and thereby improves Bank’s rating.
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The difference between gross NPA and net NPA explained
